Why Bed Bath & Beyond Shares Got Soaked

In this Market Foolery podcast segment, host Mac Greer is joined by David Kretzmann and Aaron Bush of Supernova and Rule Breakers to dig into the slow-motion collapse of a retail chain operator that didn't have to wind up in such bad shape. Bed Bath & Beyond (BBBY) management's financial strategy took the company in the wrong direction a few years ago, and the result has left it laden with debt and behind the curve in doing what it needs to lure customers back into its stores.

A full transcript follows the video.

This video was recorded on Sept. 20, 2017.

Mac Greer: Let's begin with, frankly, a retailer that I have pretty much forgotten is still around -- Bed Bath & Beyond. Wow, Bed Bath & Beyond taking a bath on Wednesday. Shares down more than 14% after the company lowered its earnings outlook and reported weaker-than-expected earnings. David Kretzmann, I go to you. Is Bed Bath & Beyond beyond repair? Is there anything you can do to save this?

David Kretzmann: What hurts here is, the stores aren't performing that well, but on the financial side of things, management has done more to add gasoline to that bad fire overall. If you go back to 2014, from a financial perspective, the company looked like it was in decent shape. It was producing over $1 billion in free cash flow annually, had $850 million in net cash on the balance sheet, so they had cash in the bank, they were producing a lot more cash to add to that tally. But that year, they decided to issue $1.5 billion in new debt just to buy back stock. They essentially went into more debt, bought back a lot of stock, and now a few years later the company has over $1 billion in net debt, and their free cash flow production has almost been cut in half to about $570 million. So that's a bleak direction to be going within just a few years.

They've really been focusing on buying back stock, they haven't done a whole lot to improve the actual in-store experience, and what they have done has been very slow. They are making some progress with their digital sales, which now make up about 15% of total revenue. They say that their "differentiated products," which they consider their exclusive products, personalizable products, makes up about half of sales, so I think that's probably an area where they really need to double down and find some way to differentiate what they're offering and how they offer it from Amazon (AMZN -1.14%) and other retailers that are still out there. They've also made some acquisitions into new brick-and-mortar retail concepts. They bought a website, personalizationmall.com, late last year, where you can buy and personalize a lot of different items. Going that route makes the most sense to me.

It's not a stock I would buy, even though it looks very cheap-looking at these trailing metrics. But I think management has made some very poor cash management decisions over the past few years, and in the meantime, the actual performance of the stores leaves a lot to be desired.

Aaron Bush: Yeah, one tidbit that I keep on coming back to for Bed Bath & Beyond and for other struggling retailers is, when a brick-and-mortar store tries to add a quality e-commerce operation, not only does it tend to cause its physical stores to struggle more, but it makes the company increasingly expensive to run, because they have to duplicate the cost just to serve that same customer. So you do see them making really dumb decisions with debt, and adding new retail concepts, which feels more like a distraction than anything. But just the fundamental structure of how the economics work, and managing an in-store presence and an online presence isn't very friendly. And they've been really slow to do this. But now that they are invested in it, it's another reason that's adding a margin drag and keeping earnings lower.

Greer: Do you think, in terms of those traditional retailers adding that online piece, I see why you would want to do it. Everyone's trying to fend off Amazon. You have to try anything. So you have Wal-Mart (WMT -0.65%) with the Jet acquisition. Do you think that's going to work for Wal-Mart? Or, to take your logic even further, if you're Wal-Mart, do you stick to your knitting, which is just bread-and-butter traditional retailers?

Bush: I think for Wal-Mart and Jet, I think it was smart to acquire Jet, not for Jet itself, but more for the talent that is in that management team. And I know, I'm blanking on his name ... Marc Lore, who was the head of Jet, now runs Wal-Mart's e-commerce operations. So I think that was smart. What Wal-Mart really needs to do is continue to acquire things and really build up a big suite of an online presence. When it comes to e-commerce, aggregation is increasingly important, so you either have to dominate a niche, or you have to be someone that you can go to for anything and everything. So it's tough. Wal-Mart might be able to pull it off, Amazon is definitely pulling it off, but for someone like Bed Bath & Beyond it's a hard spot.

Kretzmann: I think what Aaron mentioned highlights why it's so difficult for these brick-and-mortar retailers to pivot more to online or omnichannel sales because it tends to be more expensive to operate both rather than one or the other. But there is some value to the omnichannel experience. You see Amazon clearly showing a lot of interest in opening up their own brick-and-mortar stores, acquiring Whole Foods. So there is value there. But for a lot of these companies, I think it will be a short-term ding, but it's probably what they need to do to stay relevant and figure out some way to hopefully improve the economics over time, one way or another, whether it's offering more personalized services or some sort of consultation.

We're going to talk about Best Buy today. They're trying to do something along those lines. But in the short term, the company needs to stomach those short-term dings if they want to stay relevant with competitors like Amazon.

Greer: So, Bed Bath & Beyond shares a lot cheaper today than they were yesterday, but you're still not interested?

Kretzmann: Based on management's track record, both managing the stores and how they've been trying to pivot those stores, I think they've been lackluster there. And they've also really jeopardized the company's financial position, because you're not going to go bankrupt if you don't have debt, and they completely pivoted the whole balance sheet a few years ago to buy back stock, which, in hindsight, looks like a very dumb move. Shares have continued dropping since then, so that was a poor investment, and a very poor reason to go into debt. So, from a financial position now, the company's future is in a lot more jeopardy now. So I would stay on the sidelines here.

Greer: So, five years from now, are they still a going concern? Are they still around?

Kretzmann: I think they're still around but they're probably getting pretty close to bankruptcy, at the rate they're going now.